In finance, when something is shorted this means that an investor has invested in a way that means that they will profit if the value of it falls.
At its most basic level shorting involves selling an asset on one date, waiting for the price to fall, and then repurchasing it at a later date at a lower price. Profit is taken from the difference between the sale and repurchase prices.
Shorting is commonly either done as a speculative move with the intention of making a profit or it is done to offset certain types of financial risk. Where it is done as speculation, it is possible that the party which carries it out will make a loss rather than a profit.
Speculation is what is discussed in this article, rather than risk hedging.
In order to understand how shorting currencies works, it’s helpful to first look at how shorting commodities works.
A common way by which an investor can short a commodity is by borrowing it over an agreed period of time. If, for example, the investor is looking to short a commodity like gold they could do so in the following way:
The big risk is obviously that the price of gold could in fact rise, rather than fall. If this happens, the investor will have to cover the cost of this in order to repurchase the gold to return it to the lender. In this case, they will make a loss.
The opposite of shorting something is known as going long and is a far simpler form of investment. When you go long on an asset, you purchase it at a certain price in the hope that the price will rise. If the price does indeed rise, you then sell it at a higher price and make a profit from doing so.
In most forms of investing, you can either take a long or a short position.
The situation in currency trading is slightly different because currencies are traded in pairs.
When someone trades currencies they do so by taking a long position on one currency and a short position on another. This is an inherent part of forex trading as currencies are always traded in pairs with their value in relation to each other determining whether or not a trader makes a profit. Being long on one currency and short on another is a constant aspect of forex trading.
That said, while a currency trade always involves a long and a short position, many currency trades are done primarily with the intention of profiting from the short position. As such, shorting a currency is often an explicit tactic used in currency trading.
Shorting a currency using spot trades is similar to shorting commodities as in the earlier example. Spot trades are currency exchanges, whereby one currency is exchanged for another at the prevailing market rate at any point in time.
In foreign exchange, when a currency is shorted this currency is known as the base currency. The currency against which it is shorted is known as the quote currency. Usually, an investor will carry out extensive planning before choosing a currency to short. On top of this, they also need to select the quote currency against which they will short the base currency very carefully.
In order to short a currency an investor could
While it is possible to short a currency with spot trades, in reality, it is often done through different means. Often contractual agreements are set up between currency traders which effectively allow for the same process to happen through different means. While these methods are different, the fundamental principle is the same and that is that the investor is looking to profit from a fall in the value of the base currency.
Forward and option trades are two examples of this kind of agreement and are often used on forex trading. Contracts for difference (CFDs) are another kind and are particularly popular in forex trading.
Essentially, in forex trading, CFDs allow people to speculate on the value of currencies without actually purchasing the relevant amount of currency. The buyer of a CFD will agree to pay the seller the difference between the current value of an asset and its value at completion of the contract.
To short a currency, you would agree with a CFD provider to settle the difference in value between two currencies after a period of time. This agreement effectively allows people to go short (or take a long position) against a currency without actually exchanging currencies.
Whatever the method by which forex trading (including currency shorting) takes place it is important to understand that it is a risky activity. People should not engage in it without having a complete understanding of what they are doing and without understanding the level of risk they are exposing themselves to.
Currency shorting is something that often happens in forex trading and there are some notable instances where large profits have been made.
The result of the Brexit referendum in 2016 caused a crash in the value of the pound sterling and this was one occasion on which many investors profited by shorting the pound.
If an investor had shorted the pound by taking a long position on the dollar on the 22nd June (one day before the vote was held), within three days they could have been able to profit from a change of 0.1347 in the GBP/USD rate. A short position on the pound with the US dollar in this instance with an initial investment of £100,000 could have led to a £10,000 profit.
One famous example of an individual shorting of a currency is 1987 shorting of the New Zealand dollar. At the time, Andy Krieger was a trader at Banker’s Trust and was speculating on currencies following the Black Monday crash of October that year.
One result of the Black Monday crash was that the investors withdrew funds that were held in US dollars and invested them into other currencies that were expected to be more stable going forward. A knock-on effect of this was that those alternative currencies became overvalued. This overvaluing, as Andy Krieger predicted, would, in turn, lead to a drop in value.
To take advantage of this, Andy Krieger took up a short position against the New Zealand dollar to the value of hundreds of millions of dollars. Eventually, the New Zealand dollar did collapse and he made a vast profit as a result. The profit he made (for his employers) was in the hundreds of millions of US dollars.
Bound exist to help businesses deal with currency risk. Currency risk is the risk that a business will lose money as a result of a change to exchange rates. By using contractual agreements, such as forward and option trades, businesses which face currency risk are able to secure exchange rates for future dates and can avoid facing currency risk by doing so.
Currency risk management is different from forex trading. While in some cases favourable changes to exchange rates can be taken advantage of by businesses that engage in currency risk management, the aim is to prevent loss rather than to speculate for profit.
Forward trades, for example, can be used to fix the exchange rate that a company receives at a future date. If a company is set to make a purchase in a foreign currency at a future date, it can fix the exchange rate that it will receive in advance. By doing so they do not expose themselves to the risk that exchange rates will change adversely before the payment has to be made.
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